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Minyan Mailbag: Convertible Bonds



Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next column with that very intent.


I think the 'Ville would enjoy a better explanation of how the convertible bond funds have lost money. In the buzz yesterday, you said, "The market, if you want to call it that, is down substantially since January."

Many Minyans will probably assume you are talking about the stock market. I am assuming you are talking about the convertible bond market.

If I have followed this whole conversation so far, these funds buy the convertible bonds, sell the stock, and buy credit insurance. In general, I would guess they are losing on the bonds, making money on the short stock and losing insurance premium. But this is just my guess and not a good one. If the convertible bonds are getting hit that hard, why wouldn't the regular corporate bond market be getting hit harder than it is? So where are the losses coming from?

Minyan JK


Convertible bonds are a unique subset of the corporate bond market. The notional value of all U.S. convertible bonds is roughly $300 billion, only about 7% of the total corporate bond market.

Convertible bond performance over the last several years has been driven by a process typical of "bubble" creation.

First, convertible bonds at a price offer an opportunity to "arbitrage" the various components that produce a relatively good return for risk. Smart market participants (the few convertible bond managers that exist) take advantage of these prices (price is the key here) and produce good returns. These good returns attract more capital, which causes the creation of new hedge funds (with marginally less talent) that enter the market and chase prices up. The process of chasing prices up causes more good returns and attracts more capital. This process continues, producing steady returns even though prices are no longer "cheap." As convertible bond prices (the basis as you describe it) increase, the risk increases exponentially while still producing returns. The risk is hidden.

Prices reach a point where a few "smarter" participants begin to exit the market. As they begin to exit, the market suddenly realizes that there is not enough liquidity for this exodus and prices collapse.

So it really is a Ponzi scheme at its extreme, just like any other bubble (the above process can be applied to any market).

Because convertible bonds are mostly controlled by a separate class of managers and this market is relatively small compared to the total corporate bond market, prices can collapse from the exodus described above without hurting the larger market. Convertible bond prices have collapsed without any significant widening of credit spreads and without stock prices going down.

At some point regular corporate bond managers will step in to buy because of the value being created by collapsing prices. Either that or credit spreads will begin to widen, thus hurting normal corporate bonds with convertible bonds not declining as much from that point. Either way, the fundamentals of the two markets must begin to align over longer periods.

If credit spreads do not widen, just when do regular corporate bond managers step in and start buying, I do not know; it may be happening as we speak. But this buying is offset by continued liquidation by over-invested and over-leveraged hedge funds. When the two reach equilibrium I just don't know; my guess is that this has a way to go before prices begin to increase.

Prof. Succo

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